HCA Deal Can't Lift Peers

By going private in one of the biggest leveraged buyouts ever, HCA ( HCA) has finally found a way to boost its ailing stock.

Shares in the giant hospital chain rose 3.4% Monday after HCA said it plans to sell itself to a group of private investors for $51 a share in a landmark deal valued at some $21 billion. The announcement confirmed rumors that began driving HCA shares higher last week.

But the announcement also comes as HCA posted another quarter of weak admissions and rising bad debt from the uninsured. And because the fundamentals remain questionable across the industry, most rival hospital chains failed to rally on the news of the big buyout.

"I understand that while earnings don't matter right now, they were really pretty awful," notes Sheryl Skolnick, senior vice president of CRT Capital Management. "If you're going to report a quarter like that, you want to have some good news -- and they do."

HCA expects to sell itself by the end of this year to a consortium of private equity investors that includes Bain Capital, Kohlberg Kravis Roberts, Merrill Lynch Global Private Equity and members of the Frist family, who founded the company. Indluding debt assumption, the transaction would be worth $33 billion, topping KKR's 1989 buyout of RJR Nabisco as the biggest LBO in history.

Still, Skolnick says, HCA secured a higher multiple when the company went private last time around. That transaction, executed the same year as the Nabisco deal, came in the midst of a tough reimbursement environment that eventually passed and allowed the deal to succeed. But some believe that today's biggest challenges -- particularly bad debt from the uninsured -- could prove harder to overcome.

Even JP Morgan analyst Andreas Dirnagl has noted some clear differences. Dirnagl has an overweight rating on HCA's stock, and his firm -- which counts HCA as an investment banking client -- owns more than 1% of the company's shares itself.

"Wall Street is like Hollywood; we love remakes," Dirnagl wrote on Monday, just before HCA officially confirmed the buyout plans. "For HCA, it's looking like the same situation as the late 80s/early 90s, namely, changes in reimbursement and insurance have led to low valuations but still high cash flow -- the definition of an LBO candidate. But HCA is a much bigger company now, the markets are weaker, and interest rates are higher than six to 12 months ago, leading to a much tougher deal to put together."

Of course, HCA now looks poised to pull that transaction off. And Skolnick, for one, believes the deal makes sense.

"The bottom line is that HCA really should be a private company," says Skolnick, who has a fair-value rating on the company's stock. "And $51 a share is reasonable -- if not sort of on the high end -- given the outlook for the industry."

Weak Vital Signs

HCA's latest results pretty much tell the story.

Second-quarter revenue rose 3.3% to $6.4 billion, topping the consensus estimate of $6.36 billion. But net income dropped 28% to $295 million amid weak admissions and the absence of year-ago gains. Meanwhile, reported earnings per share of 72 cents -- which included 13 cents worth of favorable adjustments to liability reserves -- fell at least a full nickel short of Wall Street expectations.

"Bad debt was the big issue," Skolnick says. "It just continues to be a problem."

To be sure, HCA has found itself providing more and more free care. During the latest quarter, the company wrote off $677 million, or 10.6% of its revenue, to cover unpaid bills. It provided $258 million in discounts to the uninsured, up 40% from a year ago. Meanwhile, charity care for the poor jumped 27% to $350 million.

Peter Young, a business consultant at HealthCare Strategic Issues, questions the wisdom behind the HCA buyout in light of those results.

"The quarter's numbers indicate the business environment is not improving," Young insists. "No question, this is the biggest private deal and the bankers are excited. But the performance of the company this quarter -- and the past year -- suggests that mouth-watering returns for new investors based on operations are likely not to be there in the future."

Appetite for Deals

Hospital investors seemed to recognize as much.

The sector posted only modest gains following Monday's big news. Notably, the remaining hospital companies must rely on their operational results to drive their stock prices unless another buyout offer comes through.

Given HCA's weak second-quarter performance, some feel, those companies cannot deliver very much. Moreover, only a few may be saved by buyouts in the end.

"Since the company is going private, no one will be spending the time on HCA's earnings that they would usually," he says. But "what would the impact of a 7-cent miss have on perceived value? I suggest it would assure (a stock price) in the lower mid-$40s range."

The stock had been hovering below $44 -- within a few dollars of its 52-week low -- before last week's buyout rumors surfaced and sparked a rally in the shares.